Betting on "Limited-Supply Products"

February 22, 2005

Commodities in limited supply are one of the best bets for investors, in the view of Pat O'Neil, president of Loring Investment. He manages a portfolio of stocks in the Loring Hedge Fund and another of waterfront real estate in the Loring Freshwater Fund. "The steel companies, the gas companies, the metals -- all these are in limited supply, and a good company with products in demand will be profitable, and the stock price will go up," says O'Neil.

Among the stocks he likes are Peabody Energy (BTU) in coal, Nucor (NUE) in steel, and Southern Peru Copper (PCU). Another of his choices is ITT Industries (ITT), which makes night-vision goggles for the military.

O'Neil founded the Freshwater Fund during the bear market to protect against another stock market correction by investing in waterfront properties. One of his favorite venues is Nova Scotia, which he says is undiscovered so far and where he has found lots at below-market prices. "We think Nova Scotia is going to be a big deal in the next five years," O'Neil says. Already, 10 Fortune 500 companies, including Microsoft (MSFT), have established call centers in Nova Scotia, he adds, as an answer to problems with overseas outsourcing.

These were some of the points O'Neil made in an investing chat presented Feb. 17 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and June Kim. Edited excerpts follow. AOL subscribers can find a full transcript at keyword: BW Talk.

Q: Pat, this upsy-downsy market was down again today -- what's your broad view of its behavior?

A: We think the market is fine, and a bouncy market during this recovery is not unusual. The market is being moved by news events, but the trend is up.

Q: What exactly is a hedge fund? And how does yours fit into the category?

A: You may have noticed yesterday in the newspaper that a New York hedge fund was trying to buy Circuit City (CC). This is a good indication of how hedge funds might do anything. In our case, we only do two things: Our stock fund invests in profitable stocks, and our real estate fund only buys waterfront lots.

The simple goal of all hedge funds is to make as much money as possible for the investors. We charge a 3% annual fee, plus, we get 15% of the profits at the end of the year. This is pretty standard for hedge funds. From that point, the fund tries to follow its managers' expertise -- and be successful.

Q: Do you think the larger pharma companies will look to buy out the smaller biotech companies?

A: Not only in the drug business, but all over, the larger companies are trying to find the new, innovative, profitable companies and bring them into the fold. The new companies need money, the old companies need a jolt of fresh profits, and usually these takeovers happen quickly.

For investors, I suggest staying away from the very large companies, because they have so many shares of stock trading that it takes a lot of volume to push up the price. The best gains are in companies that are trading less than 100 million shares.

Q: Would you be buying Pfizer (PFE) now?

A: I would wait and not buy the big drug company stocks until the market has stabilized. We probably have another two months to go, but I would not put money in the big drug companies right now.

Q: Pat, what investment strategy would you recommend for the current market, assuming a fairly long horizon?

A: I think investors should be looking at stocks that will continue to be in demand, and that means companies dealing with limited-supply products. Specifically, this means commodities and some types of real estate. The steel companies, the gas companies, the metals -- all these are in limited supply, and a good company with products in demand will be profitable, and the stock price will go up.

A: Yes, it is. There's an absolute limited supply of waterfront lots with an increasing demand as the baby-boomer group rolls into retirement. I'm sure you've seen lot prices go to the sky all over the country. And yes, that's the real estate fund.

Q: Building on the small-company idea, what do you think about small banks in fast-growing geographic locations?

A: I think that's a great idea. There's a bank in San Francisco called UCBH Holdings (UCBH). These people specialize in loans to Chinese immigrants. Of course, their market on the West Coast is being fed by Chinese coming in from Asia, and with a bank targeted toward their needs, UCBH has been very successful. They pay a dividend and have been profitable for the last 10 years.

A: I think the smaller-cap dividend stocks are going to have a good two years ahead. The mutual-fund investors are looking for exactly that type of stock. The dividend is a bonus for the mutual fund, and the appreciation in the value is better than in the larger companies.

The large-cap dividend stocks often get caught up in making the dividend payment and aren't as focused on the appreciation of the stock value as the small-cap stocks are....The smaller-cap stocks tend to be more innovative, ending up paying you both the dividend and the appreciation of the stock value.

Q: Any specific small caps that you're interested in?

A: We own a few small-cap stocks in my hedge fund. One is Peabody Energy (BTU). They're the largest coal manufacturer in the U.S., and the demand for coal, surprisingly, is three times that for oil and natural gas. Cleaner production of coal is becoming a reality, and that's increasing the demand.

We own one other diversified stock, called ITT Industries (ITT). They're in the defense business and manufacture night-vision goggles for the military.

Q: Do you recommend any other companies in the defense business?

A: Textron (TXT) is in the aircraft and helicopter business, and they provide parts and equipment for Bell helicopters and Cessna airplanes. This is another small-cap stock with a long (10-year) profitable history, paying a fat $1.40-a-share dividend.

Q: How is your new defensive real estate fund doing?

A: That's our Loring Freshwater Fund, and we started that during the bear market to make sure we didn't get hit again in a big stock correction. Freshwater is up 10% this year, and it's due strictly to finding waterfront properties at below-market cost. I've taken a big position on oceanfront lots in Nova Scotia, and we expect that area to develop just like Vancouver, B.C., did in the 1980s.

Q: Why Nova Scotia?

A: Location and price are the reasons. We like the fact that Nova Scotia is placed nicely between the eastern U.S. and Europe. The land boom in prices has not hit Nova Scotia yet but will begin this summer. We had been following the pricing of lots, and it's beginning to sneak up. This is an undiscovered area.... We noted that Microsoft (MSFT) has opened a call center in Nova Scotia, and they're the 10th Fortune 500 company to do so. They're looking for an answer to problems from overseas outsourcing, such as phone centers in India. We think Nova Scotia is going to be a big deal in the next five years.

Q: Do you like anything among the technology stocks?

A: On the technology stocks, I guess I should first talk about e-commerce, because it's here to stay. eBay (EBAY) is still a good stock, as they have a lot of growth left worldwide. I think Google (GOOG) is just beginning to find its path. Advertising on the Internet is still in its infancy, and Google has a corner on the market. I like both of those stocks and a medical-tech stock called Intuitive Surgical (ISRG). They make a robot that performs surgical techniques for heart operations and prostate operations.

Q: What's your opinion on gaming stocks? Las Vegas Sands (LVS)?

A: Las Vegas Sands just went public, and they're having tremendous growth. They run the Venetian and the Sands in Las Vegas. The gambling business is going to continue to grow, both for the casinos and the slot-machine manufacturers.

The one point that investors have to watch is complacency on the part of management. Once companies like International Game Technology (IGT), the big slot-machine maker, get too big, the motivation for employees goes out the window. Everyone has stock options and long vacations, and it's difficult to get that fire burning again. The smaller-cap gambling stocks are the best bets.

Q: You've mentioned medical stocks in this chat. Why do you like them?

A: Health care is obviously here to stay, and in our country, the demand to be well and live longer is very strong. There will be no end to the demand on government to provide health-care services for people who need them. The cost-cutting plans in health care in general have run out of rope, as new companies start in the health-care business or medical-devices field. The demand will not stop.

Q: How about energy stocks? An opinion on XTO Energy (XTO)?

A: XTO has ridden the wave of oil and gas stock prices in the last year. The company is profitable, but so are just about all of the gas and oil stocks in the index today. I would be cautious in how much of your portfolio ends up in oil stocks -- I think it would be a better idea to take a broader position in commodities. There's a steel company called Nucor (NUE), and they have a technique to recycle old steel into new raw materials.

Another one is Southern Peru Copper (PCU), a company based in Peru with tremendous sales growth, as the demand for copper continues against a limited supply. I would look at any profitable commodity company and try to balance your investments with an equal percentage in each, rather than overloading in oil.

Q: Do you have any choices among the consumer stocks?

A: Well, Best Buy (BBY).... They've taken a nonspecialty business and trained their employees to excel against the competition. On the e-commerce side, I'd wait on Amazon (AMZN) because they seem to be scrambling now to figure out what business they're in.

A company that manages e-commerce is named Digital River (DRIV), and they place themselves between the customer online and the manufacturer, so they perform the service of collecting the money while maintaining the e-commerce Web site. I think this idea of being a specialist will work long term in e-commerce, just as Google is becoming an advertising specialist. DRIV sales and profits are growing at 40% per year.

Target (TGT) as a retailer is a good bet. They know how to market to the public. Wal-Mart (WMT) would be one of the "too big to buy" stocks -- it just takes too much energy to push up the stock price.

Q: What's your forecast for the market by the end of the year? Last time you used the number 11,000 on the Dow.

A: Thanks for remembering -- we were shooting for 11,000 on Jan. 1 and got to 10,800. So we didn't quite get there. I think we can expect a better year for the Nasdaq than the Dow, and if we get the Nasdaq above 2,200, you can look for a strong run of about 15%. I still expect the Dow to make 12,000, and I'll say certainly some time this year. I would also like to invite you to the Stockbook.com Web site, and I would be happy to have you sign up for my free weekly newsletter.